New guidance: Trader funds on 163(j) interest expense limits
On July 28, the Treasury Department released final regulations (TD 9905) and proposed regulations (REG-107911-18) providing guidance on the business interest expense limitation under Internal Revenue Code (IRC) Section 163(j). The regulations provide direction on several issues impacting the financial services industry, with further clarification on the application of the Section 163(j) limitation for trading partnerships.
Section 163(j) limits a taxpayer’s business interest expense to the sum of:
1) 30% of adjusted taxable income (ATI) for that year (increased by the Coronavirus Aid, Relief, and Economic Security (CARES) Act to 50% of ATI for taxable years beginning in 2020)
2) its business interest income
3) floor plan financing interest
Before the release of the latest guidance, trader funds were considered to be engaged in a trade or business activity and subject to the Section 163(j) limitation on “business interest expense” at the partnership level. Any interest not limited at the partnership level, and allocated to investors who did not materially participate in the trading activity, was treated as “investment interest expense” in the hands of those partners and, therefore, subject to limitation at their level for purposes of section 163(d).
Multiple comments were received by the Treasury Department and IRS questioning the interpretation of the two mentioned code sections and asserting that interest expense should not be subject to a double limitation under both section 163(j) and section 163(d).
The newly proposed regulations now require a trading partnership to separate its interest expense from trading activity between partners that materially participate – the general partner(s) and limited partners who are passive investors. The 163(j) limitation would only apply to the portion of interest expense allocable to the materially participating partners at the partnership level.
The portion of interest expense from a trading activity allocable to passive investors will not be subject to the 163(j) limitation on business interest expense at the partnership level. It will only be subject to the investment interest expense limitation under section 163(d) at the partner level.
The newly proposed regulations have clarified that limited partners in trader funds are not subject to two sets of limitations on their interest expense. The proposed regulations generally are not retroactive, although taxpayers may choose to apply them to tax years beginning after Dec. 31, 2017. Trading partnerships with significant disallowed interest expense under 163(j) may want to consider revising prior year tax returns.
There are other aspects of the new guidance that will have implications for the financial services industry. Additional alerts will follow.
Robert Richardt, CPA, Partner
Mark Papa, CPA, Senior Manager
Justin Williams, CPA, Senior Manager
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